In two unanimous decisions handed down by the New Jersey Supreme Court guaranteed that uncertainty would continue to reign over the process of valuing minority interests in closely held corporations. In the two decisions, the Court came out in opposite ways on the same issue - whether to apply a marketability discount in valuing the closely held shares.

In Balsamides v. Protameen Chemicals, 734 A. 2d 721, NJ: Sup. Ct 1999, the Court held that such a discount should apply in a court-ordered buyout of the stock of an oppressing shareholder under the oppressed minority shareholder statute.

In Wheaton v. Smith, 734 A. 2d 738, NJ: Sup. Ct 1999, the Court determined that, in a statutory appraisal action, a marketability discount should not apply to the shares of the dissenting shareholders of a family-owned company.

The Court acknowledged that it was unable to pronounce a consistent rule other than to articulate as the guiding principle in both cases that "a marketability discount cannot be used unfairly by the controlling or oppressing shareholders to benefit themselves to the detriment of the minority or oppressed shareholders."

In effect, this "principle" means only that application of a marketability discount is not just a matter of economic theory or valuation methodology but, rather, something that will depend on what is fair and equitable under the circumstances, which in the context of shareholder disputes is often difficult if not impossible to predict.

Balsamides v. Perle

The Balsamides case presented a typical corporate "divorce" scenario. The two shareholders, Balsamides and Perle, each owned 50 percent of Protameen Chemicals, Inc., a successful chemical business. Perle was the "inside" man, with technical and administrative responsibilities. Balsamides was the "outside" man, responsible for sales and marketing.

Each man had two sons who eventually were employed by the company in the areas controlled by their fathers. As time went on, each of the coequal shareholders came to feel he played a more important role in the business than the other, each felt unfairly treated and abused by the other, and the feud developed into what one witness described as a "re-enactment of the Hatfields and the McCoys."

Balsamides and his sons sued Perle and his sons under the oppressed shareholder statute, which permits an action by a minority shareholder who claims to have been treated "oppressively or unfairly" by those in control. As a measure of relief, Balsamides sought an order compelling Perle to sell his 50 percent interest in the company to Balsamides. Perle counterclaimed, alleging abuses by Balsamides.

In the course of a 19-day trial, Balsamides' expert determined that Protameen had a value of $4,176,400, after applying a 35 percent discount to reflect a lack of marketability. Perle's expert did not apply such a discount, and valued the company at $8 million. The court sided with Balsamides, and ordered the sale of Perle's shares to Balsamides at a net figure of $1,960,500.

Appropriateness of Marketability Discount

One of the key issues on appeal to the Appellate Division was the appropriateness of the marketability discount. As distinguished from a minority discount, which adjusts for the lack of control over the business entity, a marketability discount is intended to reflect the lack of liquidity in one's interest in a closely held business.

Whether either or both of these discounts should apply to value closely held business. Whether either or both of these discounts should apply to value closely held minority interests has been a subject of much scholarly and judicial debate.

In Balsamides, the Appellate Division had refused to apply either a marketability or minority discount, finding that "neither fairness nor equity" required a 50 percent shareholder whose interest was purchased by the sole surviving shareholder to receive less than half of the fair market value of the entire corporation.

On certification to the Supreme Court, the primary issue was the appropriateness of the marketability discount. On this issue, the seven justices apparently differed with the three Appellate Division judges as to what was fair and equitable under the circumstances.

Not an Exact Science

The Supreme Court began its analysis by admitting what practitioners and experts in this area have long known (but seldom acknowledged publicly): that "valuation of [a] closely-held corporation is not an exact science," "that it was more an art than a science," and that "[t]here is no right answer."

Conceding that there could be reasoned differences of opinion, the Court stressed that the trial court's evaluation of the credibility and reliability of the parties' experts and of the testimony of the parties themselves was entitled to great weight.

Indeed, the Court found that the oppressed minority shareholder statue vests a large measure of discretion in the trial court on valuation issues. For one thing, the statue used the term "fair value," a broader and more flexible standard than the "full market value" language used in a prior statute. "Fair value" was expressly defined in the statute as an amount "deemed equitable by the court, plus or minus any adjustments deemed equitable by the court if the action was brought" under the minority shareholder statute.

Public Policy Plays a Role

The Court looked to both public policy and the particular facts of the Balsamides case to determine whether application of a marketability discount was fair and equitable. First, the Court found that, unless a marketability discount were applied to Perle's shares, Balsamides would be left to absorb the full reduction for Protameen's lack of marketability.

The Court reasoned that the company stock would remain illiquid (because it was not publicly traded and information about the company was not widely disseminated), even after Balsamides purchased Perle's interest.

On the other hand, had Perle and Balsamides sold the business together, they would each have shared pro rata in the price reduction due to Protameen's illiquidty. Second, the Court adopted the trial court's characterization of Balsamides as the oppressed shareholder and Perle as the oppressor, whose "vendetta" against Balsamides "was harmful to the business of Protameen and displayed little or no regard for the welfare of his own company and the interests of his partner."

Because the Court found "the equities of this case quite clearly lie with Balsamides," it was unfair to allow Perle to receive the corporation's undiscounted value.

Thus, the Court announced the following rule:

[W]here the oppressing shareholder instigates the problems, as in this case, fairness dictates that the oppressing shareholder should not benefit at the expense of the oppressed. Requiring Balsamides to pay an undiscounted price for Perle's stock penalizes Balsamides and rewards Perle. The statute does not allow the oppressor to harm his partner and the company and be rewarded with the right to buy out that partner at a discount. We do not want to afford a shareholder any incentive to oppress other shareholders.

The Balsamides holding can be justified in the factual context of the Court's opinion, even if it lacks any convincing economic rationale. Other factual contexts are problematic, however. First, it may be important that there were only two shareholders and that they held equal interest.

The Balsamides rule may not work so clearly when there are several shareholders, only some of whom are involved in the feud. Assume, for instance, that there are three coequal shareholders and one is the manager of a closely held company. A feud develops between the managing shareholder and one of the other shareholders which results in a court-ordered buyout.

Balsamides was perhaps an atypical dispute which involved two coequal shareholders, rather than majority and minority interests or a number of shareholders each having less than a majority of the shares. Because the Court did not speak directly to the minority discount, it is unclear whether any circumstances would ever warrant application of a minority discount.

Wheaton v. Smith

In a companion decision to Balsamides, the Court addressed the appropriateness of applying a marketability discount in determining the "fair value" of shares held by dissenting stockholders in a statutory appraisal action. In Wheaton v. Smith, 734 A. 2d 738, NJ: Sup. Ct 1999, the Court concluded that a marketability discount should not apply in such situations but left open the possibility that it could in some limited circumstances.

The rather complicated facts of Wheaton centered around a challenge to a corporate restructuring of a closely held family-controlled business that had begun in 1888 as the Wheaton Glass Company. Over the years, as the Wheaton business grew and diversified, members of the Wheaton family continued to own virtually all of the stock of the company, which by the 1990s amounted to over five million shares.

In 1991, the Wheaton board considered a restructuring plan as part of a proposed initial public offering (IPO) of limited voting common stock to the public. The IPO was favored by a majority of Wheaton shareholders because it would provide liquidity to pay federal estate and fight tax liabilities.

At the time, the investment bankers who were proposing to underwrite the IPO estimated the per share value of Wheaton at between $57 and $68. Meanwhile, a foreign company purchased the stock of Wheaton's former president and made an unsolicited offer to purchase all of Wheaton's stock for $64 per share.

The Wheaton board rejected the offer, and the majority of Wheaton's shareholders agreed to restrict any sale of stock to an outsider party unless the sale were approved by 75 percent of all shareholders and by a newly created shareholder committee.

Minority Shareholders Demand "Fair Value"

In contemplation of the IPO, a restructuring plan (which involved a change of name and transfer of substantially all assets to three newly created wholly owned subsidiaries) was approved on December 5, 1991, by holders of more than two-thirds of the outstanding stock. However, 26 shareholders (comprising of 15 percent of the shares) dissented from the plan and demanded the "fair value" of their shares under the New Jersey appraisal statute.

In early 1992, First Boston conducted a fair value appraisal and, after factoring in a marketability discount of 25 percent, valued the company at between $36.87 and $42.53 per share. The Wheaton board thereafter offered the dissenters $41.50 per share.

The offer was rejected, and the appraisal action was commenced. Because of the appraisal litigation and fraud which had been discovered in the fall of 1991 at a Wheaton subsidiary (resulting in a $13 million loss), Wheaton did not proceed with the IPO. The Wheaton's financial condition deteriorated further and, in 1995, the board voted to rescind the restructuring. In May 1996, Wheaton announced its merger with a Swiss holding company, under which Wheaton shareholders would receiver $63 per share.

The trial court determined that fair value as of December 5, 1991, was $41.05 per share, slightly less than the company's offer. On the appropriateness of a marketability discount, the trial court summarized the arguments and case law from other jurisdictions but did not decide the issue.

Instead, applying Section 7.22(a) of the American Law Institute's Principles of Corporate Governance: Analysis and Recommendations, it found that "extraordinary circumstances" existed to warrant such a discount. On appeal, the Appellate Division concluded that the weight of authority rejected the marketability discount but it affirmed the trial court's findings as to valuation, including its finding of "extra-ordinary circumstances."

Supreme Court Rejected Marketability Discounts for Fair Value

On certification to the Supreme Court, the justices unanimously ruled that "marketability discounts generally should not be applied when determining the 'fair value' of dissenters' shares in a statutory appraisal action." The Court thus followed the majority of states, most commentators and the American Law Institute (ALI), which view such a discount as creating a windfall for majority shareholders while penalizing minority shareholders for the exercise of their statutory appraisal rights.

To hold otherwise, said the Court, "would inevitably encourage corporate squeeze-outs." The Court made plain that its ruling was not intended to apply to valuations made for purposes such as tax or equitable distribution, where discounts for minority status or non-marketability might be appropriate.

For statutory appraisal actions, the Wheaton, decision, in effect, adopts the rule set forth in 2 ALI, Principles of Corporate Governance: Analysis and Recommendations, paragraph 7.22. Under those principles:

the fair value of shares ... should be the value of the eligible holder's proportionate interest in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability...

Under Comment 3 to Section 7.22(a), "extraordinary circumstances" exist "only when [the court] finds that the dissenting shareholder has held out in order to exploit the transaction giving rise to the appraisal so as to divert value to itself that could not be made available proportionately to other shareholders."

According to the Supreme Court, "most appraisal cases involving family-held corporations concern family feuds...[and] [t]o find such circumstances extraordinary would be inconsistent with the purpose of the Appraisal Statute." Here, the Court found that "the dissenters merely pursued their lawful options" and, thus, the appraisal rights were no more than "the ordinary consequences of the restructuring plan."

Later Share Price Could be Considered for Fair Value

The Court also ruled that the trial court improperly excluded evidence of the 1996 acquisition price of $63 per share and remanded the matter for consideration of this evidence on value.

The Court found that the subsequent arms length transaction at a much higher price - despite the company's decline in the period after December 1991 - was relevant to assessing the original offer of $41.50 per share. To make it absolutely clear to the trial court, the Supreme Court stated that "the revaluation cannot result in a lower 'fair value' per share than $56.70, the value Wheaton's expert found before applying the marketability discount."

For valuations done in connection with statutory appraisal rights actions, therefore, the Wheaton case makes the non-application of marketability discount reasonably clear. In the shareholder divorce context, however, the Court's decision in Balsamides unfortunately offers no easily applicable rule for when to use a marketability discount. In those contexts, the court can only say "it depends."

Conclusion

In the closing for the Balsamides case, the Supreme Court summed it up best,

The guiding principal we apply in this case and in the Lawson Mardon Weaton is that a marketability discount cannot be used unfairly by the controlling or oppression shareholders to benefit themselves to the detriment of the minority or oppressed shareholders. Balsamides at 738.